An in-depth look at an up-an-coming investment strategy
Creative real estate comes in all shapes and sizes. Seller carryback, wraps, master leasing, and lot splits are a few that come to mind. However, there’s one creative strategy I’ve been following closely since 2017: accessory dwelling units or ADUs. The strategy is becoming more popular due to government intervention, societal trends, and a red-hot real estate market. It may not be in your backyard yet (pun intended), but homeowners and investors alike will want to put this strategy on their radar.
What is an accessory dwelling unit?
Generally speaking, an accessory dwelling unit (ADU) is a second structure on a property with its own separate cooking, sleeping, and living facilities. The structure can be attached, detached, or located in attics or basements. Some states and municipalities allow owners to convert garages called an efficiency unit or Junior Accessory Dwelling Units (JADUs). For multifamily and commercial, ADUs can be the conversion of underutilized areas within the building like parking or unused amenity spaces.
ADUs can be stick-built, modular, manufactured, 3D printed, and if a city allows, tiny homes.
Low Inventory: If builders could build more, they would. Despite high builder sentiment and consumer demand, builders have yet to return to the glory days experienced in peak years like 2004-2006. According to the National Association of Home Builders (NAHB), the top five issues builders face in 2021 include building material prices, timelines to receive materials, cost and availability of labor, concerns about employment and the economic situation, and the cost of the availability of building lots. That last point is a little concerning. It wasn’t just the builders who took a breather after the Great Recession. Developers weren’t focused on developing land, which is a long, expensive, and often political process.
Politics: Affordable housing is a known issue at the state and local levels. It’s not unusual to see politicians run on grand campaigns of bringing new affordable housing to market only to realize once in office that development is a complex, painful, and political process that can take decades. States like California simply gave up and started regulating at the state level. Not all cities were happy that the state forced their hand, but the new rules help solve their NIMBY problem.
NIMBYs: The not-in-my-backyard movement has more impact than most appreciate. Local electeds are put into office by local citizens. When anything different is introduced that may change the character of a neighborhood, these local advocates come out loud, ultimately stopping projects. However, it’s not just fear that a neighborhood may change. A supply-constrained market is also one where prices typically escalate. So, while some of NIMBYism is fear-based, we can’t ignore economics. When California gave all property owners, by right, the ability to build at least one ADU without the interference of the municipality, it stripped NIMBYism along with it. As municipalities tried to find ways around the rules, state legislators have continually come back to make clear that ADUs would remain a viable option to meet statewide housing goals. Updated rules have included a limit to impact fees, blocking requirements of owner occupancy, and stripping HOAs from blocking JADUs.
Money: Some cities have complained about losing local zoning control and the ability to charge impact fees. However, ADUs solve numerous money-related issues for cities. ADUs leverage existing infrastructure and prevent sprawl adding inventory on the market without the painful and expensive process of development and planning. Cities don’t have to build new streets, expand utility systems, or create new schools. California specifically allows owners to not replace parking as long as the ADU is within a half-mile from public transit, which promotes leveraging systems already in place. Most importantly, ADUs get Main Street money to the table helping cities with affordable housing instead of everyone relying solely on the government.
Who should care?
Homeowners: It appears that remote work and distance learning are here to stay. This changes the space needs of homeownership since the home is now where we live, work, and educate. ADUs are a way to make that happen. Additionally, homeowners looking to augment income can use ADUs to add beautiful and functional space to a property at a reasonable price to generate extra income for college, retirement, vacations, or to simply pay off the mortgage quicker.
Residential Landlords: ADUs are a huge opportunity for residential landlords. It’s almost impossible to build a new detached home for $80,000-$150,000 when you account for the costs of land, materials, and government fees. Landlords have existing inventory, access to private capital, experience managing tenants, and they understand that thoughtful design is important to increasing property values and quality of life for tenants. Would you be willing to spend $100,000 to build a new ADU that rents for $1,500 on an existing rental? Does this change your average vacancy rate? Cash flow? Depreciation? Quality of tenant you’re able to attract?
Commercial Landlords: ADUs on the commercial side come with fewer politics. If you own multifamily or commercial, chances are you won’t have any NIMBY issues as you’re operating in zoning meant for density. In California, multifamily and apartment owners have the ability to add up to 25 percent more units by converting unused storage, parking, or underutilized amenity spaces. If you have a 20-unit apartment, that’s potentially five additional units. Owners can also build up to two detached units.
Not every state has ADU regulations. Even if they do, it may not be available for all owner or property types. However, let’s explore ways other investors are making this strategy work in hopes your location will soon have ADUs as an option.
Flippers: Adding ADUs is likely not a good flip strategy, at least for now. In hot markets where inventory has been hard to come by, investors have spent the last few years creating deals by adding square footage like an additional bedroom and primary bathroom. But there’s a big difference between adding square footage and building ADUs. With ADUs, an investor is building the most expensive square footage (kitchen and bathroom) in a small footprint. An appraiser, unable to find like-kind comparables, will create a general cost per square foot and average it out across the entire property. This won’t work in your favor. However, as states lock down ADU regulations and municipalities finalize ordinances, lenders will come around eventually as their refinance business slows. The market needs a hybrid mortgage product willing to consider comparable sales but also include the income potential of the secondary unit. Until then, expect challenges on flip appraisals with ADUs.
Example ADU Strategies
ADU projects are creative in their own right. Leave it to investors to take it to the next level and find more creative strategies within the strategy.
Kristi Cirtwill is an investor based in Southern California who specializes in hoarder homes. She recognized the ADU opportunity early and was one of the first to tackle ADUs in multiple Southern California counties. One current creative project she’s working on involves a lot split plus ADUs. She is pursuing a lot split where she will then build an ADU on the property and then build a new home plus ADU on the new lot once it’s split. It’s taken over a year in permitting, unfortunately, but prices have increased in the market making the project even more valuable.
Ward Hanigan is a well-known educator and investor out of San Diego who focuses on what he calls dingbat rentals. His average length of tenancy is 25 years as he focuses entirely on Section Eight senior housing. ADUs are ideal for his strategy as he always targets bungalow-style properties that are single-story, one-bedroom, and around 500 square feet. He’s targeting a specific block where properties feature a detached garage that backs an oversized alley. He’s approaching owners with the concept of converting the garages to an ADU on his dime and he will manage it in exchange for a forgiveness note. When the owner(s) pass, the heirs inherit an income-producing asset. Yes, Ward does not own the property!
Retrofit1 is a design and build firm in California that specializes in retrofitting soft-story buildings to meet the current California building code. Tuck-under parking on 1970s multifamily performs poorly during large earthquakes. Instead of commercial owners spending $60,000 to upgrade parking, Retrofit1 is helping them convert the tuck-under parking into income units while simultaneously complying with retrofitting requirements.
Finding ADU Opportunity in Public Records
There are a few tactical ways to identify ADU opportunities in public records. Some ways are augmented by your local knowledge of a local market.
Property Size: ADU contractors say they are looking for a minimum lot size of 7,500 square feet while the primary residence is 2,500 square feet or less. The number of stories will come into play, but the goal will always be to have enough room on-site to create an ADU that meets local building code while creating a functional and well-designed space that keeps both tenants happy.
Upzoning: Investors are finding opportunities on properties that have been upzoned but where the owner never took advantage of the opportunity. In California, if an investor purchased a triplex lot with an SFR on-site, the investor could scrape and build a new triplex and add three ADUs to the site for a total of six units. Although there are six separate units, when it comes to financing, this is a triplex with three ADUs, which qualifies for 1-4 SFR financing.
Site-Specific: Some cities have particular areas where ADUs are easier to implement for a variety of site-specific reasons including oversized alleys, detached garages, utility location, or corner lots.
Building Type: The Retrofit1 example of turning multifamily properties with tuck-under parking into new income units while meeting new builder code is an exciting win-win example. In public records, you could do a search for multifamily but specific construction will have to be researched.
Using a tool like PropertyRadar, you can search public records for the data mentioned above to start identifying ADU opportunities in your area of choice.
Build an ADU
As mentioned, ADUs can be constructed in various ways including stick-built, manufactured, 3D printed, and even tiny homes. Your local building ordinances will guide you as to what is possible.
Adding a new stick-built structure to an existing property may not always be the fastest or least expensive but offers the flexibility of design to perfectly match the existing structure. Timelines and costs will vary greatly.
If you haven’t toured a manufactured home lately, do so. Manufactured homes look nothing like the wobbly boxes of the 70s. Today, manufactured homes can be of better quality due to their factory-built environment. With investors complaining about finding labor and high material costs, there’s something to be said about being able to place an order and having the structure delivered and ready to rent in just a few months. The biggest frustration investors will face by mixing inventory on a property is financing. If you buy a manufactured home from Berkshire Hathaway’s Clayton Homes and plop it in the backyard on an existing residence, a lender will have a hard time getting it appraised and they may give you very little, if anything, by way of financing for the ADU.
Manufactured housing should not be confused with modular, flat-pack, or prefab construction. While all are constructed in a factory, a prefab home is built, shipped, and assembled on a permanent foundation. Eventually, prefab will play an increasing role in making construction cheaper, faster, and at higher quality.
3D printed housing has made some strides in the past few years. ICON and Mighty Buildings are both now building projects in the U.S. and others are popping up. Since 3D printing manufacturers specialize in smaller units, their product is perfectly timed with ADU trends. Costs vary greatly by the manufacturer with ICON really pushing boundaries to push costs to new lows printing with their own substrate.
Tiny homes are typically regulated under the department of motor vehicles. These units are personal property, not real estate. Investors exploring tiny homes are purposefully doing so because of the price point, speed of product delivery, and typically no impact on property taxes. Amazon started promoting container homes on its site a few years ago. IKEA just announced its partnership with Escape offering a 187-square-foot model starting at $47,551. The site lists financing available for $350 a month.
What if ADUs Are Not an Option in Your City, Yet?
Apologies if I’ve gotten you excited about the concept that’s not available in your state or municipality yet. This is where you come in.
Over the years as I’ve served on nonprofit boards, I’ve picked up one of my favorite sayings: “When you’re not at the table, you’re on the table.” This simply means when you don’t show up, not only is your voice not heard, you get volunteered for things you would have never agreed to do. From the investor perspective, it means we are continually positioned as the wealthy landlord with no heart that doesn’t care about the community or neighborhood and we’re only there for profits.
Municipalities need investors to make affordable housing work. Investors involved in their local communities are not only first to be aware of opportunities, but they are also often the ones shaping opportunities. Be it serving on the planning commission, showing up to council meetings, or pitching ADUs to the mayor, we have a role to play in housing. ADUs are a creative strategy that’s now on your radar.